Emerging Markets: Value Opportunity or Trap?

But they’re also cheap for a reason — meaning that investors are better off keeping their powder dry than jumping into an asset class where the risks outweigh the rewards.

Emerging Markets Trading at a Deep Discount

As mentioned, valuations for emerging markets are certainly compelling. USAA’s investment management wing, which has quietly amassed over $57 billion in assets under management, makes the valuation case for the emerging markets in its 2014 Investment Outlook[1]. The company notes:

“The price-earnings ratio for U.S. small-cap stocks … jumped 25% in 2013. In Europe, the P/E ratio rose 20%, and U.S. large caps increased nearly 18%. Emerging markets’ P/E, on the other hand, slipped about 2%.”

The result, according to USAA, is that emerging markets now feature valuations well below that of the emerging world: The MSCI Emerging Markets Index closed 2013 with a P/E of 10, versus 13.5 for the developed-market MSCI EAFE and 15 for the S&P 500.

These low valuations are reflected in ETF Database’s list of the 100 ETFs[2] with the lowest P/E ratios. No fewer than 19 of the top 25 ETFs on the list are invested in emerging markets. The lowest in the category is the Market Vectors Russia Small-Cap ETF (RSXJ[3]), with a P/E of just 4.85.

These valuations obscure the fact that the emerging markets retain their growth advantage relative to the developed world. Although the rate of change in the developed markets is more favorable — heading up instead of down — the emerging world continues to a grow at an annual rate about 3 percentage points above the developed countries. And if growth in established economies indeed picks up, that should feed directly into the growth rate of emerging markets.

Faster growth, lower valuations: It seems like the ideal combination, especially with investment dollars continuing to slosh through the global financial system in search of opportunities. And in time, it will be — but not yet.

Two Key Headwinds Argue for a Wait-and-See Approach

Emerging-market stocks are vulnerable to two sources of headline risk that could cause values to become even more attractive at some point later in the year.

First is the potential for a correction in developed markets. U.S. stocks haven’t had a meaningful correction in well over a year, and it isn’t reasonable to expect that the current upward trajectory will continue indefinitely. When the inevitable downdraft occurs, expect the emerging markets to underperform — as is the nature of lagging investments. Already, this process may be playing out: While the U.S. market is down 1.7% so far in 2014, the iShares MSCI Emerging Markets ETF (EEM[4]) is off 4.3%.

Second, emerging markets remain vulnerable to headline risks. The potential for a disruption in China is certainly the largest variable, but it’s also the most well-known. What might be less appreciated is the possibility of a repeat of last year’s currency volatility in the “fragile” economies such as Brazil (EWZ[5]), Turkey (TUR[6]), Indonesia (EIDO[7]), Thailand (THD[8]), South Africa (EZA[9]) and India (EPI[10]). All of these countries are dependent on external capital to fund their deficits, meaning that if investors turn off the spigot — as they did during the spring/summer of 2013 — their currencies and financial markets will feel the effects in dramatic fashion. With the Fed tapering its quantitative easing policy, the potential for further outflows of investment capital remain very much in place.

Add it up, and the downside risks continue to outweigh the potential upside in emerging market stocks.

This is underscored by the chart of the Vanguard FTSE Emerging Markets ETF (VWO[11]), which can’t make sustained headway and is still dangerously close to its long-term support near $35. The ETF still was at $39.81 on Tuesday morning, meaning the VWO still has around 13% to fall before breaking down, but that cushion is less than the 17% drop the ETF suffered in its six-week downturn last spring.

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Bottom Line

Keep your powder dry, and be careful not to interpret short-term rallies as an “all-clear” signal. At some point in the next six months, emerging markets will provide an opportunity to take advantage of the valuation disparity versus their developed-market counterparts, but that time isn’t here just yet.

Wait for the other shoe to drop before committing fresh capital to emerging markets.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.